Friday, August 10, 2007

Setser's magnum opus: the balance of financial terror

Brad Setser's recent blog post is a wonderful overview of the present balance of financial terror between the US and China -- we buy their products, they finance our profligate spending. I used to post a lot on this topic, but I stopped after a while since I thought all the issues had been laid out and nothing was changing. Brad summarizes the latest developments -- the threat of new trade legislation making its way through Congress, and growing public recognition in China that it isn't in their interest to continue accumulating such huge ( > $1 trillion) positions in US debt.

The other day I was listening to Jim Cramer's CNBC armageddon rant and one little thing that shocked me was his explicit claim that the Fed was afraid to cut rates because of what it would do to the dollar. That brought back to me the doubly precarious position markets are in -- on top of the sudden liquidity crises in credit/housing we also have the real possibility of a dollar meltdown if the Fed steps in to cushion the landing.
Setser: ...He Fan (of the Chinese Academy of Social Sciences) published an oped in the China daily suggesting that China might sell (one day) some of its treasuries. Xia Bin (director of the State Council Development Research Center) suggested that China should use its financial leverage to keep a few “silly senators” from setting US-Chinese economic policy. Treasury Secretary Hank Paulson dismissed the risk that China would ever cut off its financing of the US. Chinese financing became an issue in the Presidential campaign. Barack Obama, for example, picked up on Bill Clinton’s (effective) 2004 line on China: "It's pretty hard to have a tough negotiation when the Chinese are our bankers."

CNBC switched from discussing which US company China’s investment authority (or its big banks) might buy next to discussing the possibility that China might not buy any US financial assets at all.

And cool heads – Michael Pettis of Peking University's Guanghua School of Management, for example – appealed for calm.

The general consensus in the US is that China cannot cut off the US without “shooting itself in the foot."

"China would be shooting itself in the foot,'' said Greg Gibbs, a currency strategist at ABN Amro Holding NV in Sydney. ``

I disagree. At least in part.

China is already shooting itself in the foot – financially speaking. It loses money every time it buys another dollar bonds. The dollar will depreciate against the RMB some day, leaving China – which finances its purchase of dollars by selling RMB-denominated debt – with large losses.

And, generally speaking, adding to a losing position adds to your ultimate losses.

China would be better off financially if it let the RMB appreciate substantially, stopped financing the US and took large losses now rather than continuing to finance the US, adding to its stock of dollars and adding to the scale of its future losses. A bank that is lending to a failing company reduces its ultimate loss by cutting the company off and taking its lumps now, not by covering ever bigger losses with new loans to avoid “turmoil.” China is in a similar position. The US isn’t a failing company, but China is lending to the US on terms that imply very large financial losses for China.

China’s real problem is that it cannot stop financing the US without shooting its own exporters’ in the foot.

Up until now, China’s exporting interests (perhaps in conjunction with all those who benefit from loose monetary policy) have driven Chinese policy. But the interests of China’s exporters aren’t quite the same as the interests of China writ large.

By the same token, the interest of US firms with operations in China – or US firms that rely on Taiwanese and Hong Kong firms with supply chains that stretch back into China -- aren’t quite the same of the interests of the US as whole. There are parts of the US economy that have benefited from China’s policy of subsidizing US consumption, and US borrowing, but there are also parts that haven’t.

This discussion isn’t purely academic. It provides the context for understanding He Fan’s now famous article in the China daily. He Fan’s writings leave no doubt that he understands the financial risks that China is taking by holding so many dollar-denominated assets. Dr. He and Dr. Zhang of the Chinese Academy of Social Sciences wrote in 2006 (in an early verion of this -- now restricted -- paper):

“Large amounts of trade surplus and foreign exchange reserves have put Asian economies in a position as hostage. Once the global imbalance is adjusted in an unexpected manner, such as sudden drop in the US dollar exchange rate, East Asian economies will be confronted with [a] huge loss.”

He and Zhang think China should adjust its policy to reduce its exposure to the United States. They write:

“continuous growth of [Asia’s] trade surplus is harmful and dangerous …. China’s enlarging trade surplus is closely related with distorted income distribution, losing of job opportunities and disproportional development between [the] manufacturing and [the] services sector. … to absorb the excessive liquidity caused by the increase in foreign exchange reserves, monetary authorities in East Asia [have] to continuously rely on sterilization measure[s], thus limit[ing] the room for monetary policies.”

Their arguments are in many ways the mirror image of arguments that I have made in the past. They don’t think a policy that increases China’s large exposure to the US dollar is in China’s long-term interest, even though it helps China’s export sector. I don’t think a set of policies that leaves the US ever-more dependent on Chinese financing is in the United States interest, even though China’s subsidy of US borrowing unquestionably helps many in the US.

The possibility that China might cut the US off is remote – barring a confrontation over Taiwan. But it also isn’t totally beyond the realm of possibility that China might someday change a policy that many in China think benefits the US more than it benefits China. That is one reason why the balance of financial terror may not be quite as stable as it now seems. The costs associating with maintaining the status quo – most notably the costs associated with China’s huge dollar position – are growing, not falling. ...

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